Poison or antidote?
Brad Stone has a post on yesterday's NY Times Blog – "Falling Valuations: Poison for Venture Capital" in which he suggests that down rounds are poison to venture capital returns. His article summarizes Fenwick & West's quarterly survey of venture capital financings in Silicon Valley, which shows that down rounds exceeded up rounds during Q2 2009.
Down rounds aren't necessarily poisonous to venture returns – instead they represent a re-calibration of a company's prospective worth. If the current investors lead the down round, it's likely they wind up owning a higher percentage of the company than they did before. The bulk of dilution falls on the prior equity holders – of course, this includes the VC investors prior equity but also includes the founders and management (common stock or stock option holders).
Ultimately, the value of an investment is a function of preferences, percentage equity ownership and the exit valuation. Interim valuations have to be reported to the limited partners of the venture investors and have to be "marked to market" because of FIN 157 but the real value is only apparent when the company exits.
The last 9 months have seen a steep decline in how the market values public companies – focus has shifted to real results – growth rates, market leadership and profitability – rather than on promise (or hopes!). Valuation metrics (multiples of stock value to earnings, sales etc.) have fallen dramatically.
As a result, many companies find themselves with a last round valuation that was set perhaps 1 to 2 years ago – a valuation pegging at a time of apparent better market conditions and certainly higher valuation metrics.
A prospective investor assesses the likely exit value of a company when considering it as an investment. The investor discounts that exit value based on perceived risk and the return they target for their investment. As public market comps fall, so do private company valuations.
If the company is doing well, the inside (existing) investors are often unwilling to let a new investor get the benefit of their work to help the company and their capital. This results in an inside led "down" round. This used to be perceived as a statement of weakness about a company but today, it's a rationale response – it's a correction in valuation.
A down round doesn't poison a company or in most cases, returns. It goes some way to correct ownership levels and establishes realistic expectations of what a company is worth.
Those are both good things – good for the company and good for the investor.
Down round are not happy events for anyone – but I think they are more of an antidote to challenging times than poison to investors or entrepreneurs. Both get to live to fight another day and make progress to a higher valued exit.